ANALYSIS: Buyback norms to separate men from boys

In early 2010 Steve Jobs asked legendary investor Warren Buffett about what Apple might do with its pile of cash. In reply Buffett said that if Jobs believed Apple’s shares were cheap then he should buy his own company’s shares through a buyback. Apple was then trading at $200 and went on to touch a high of $700 over the next few years. But Jobs did not go in for share buyback as he had seen bad times and knew the value of having cash in hand. His successor Tim Cook, however, announced a buyback plan and increased the size recently to $60 billion, with the stock trading at around $400. The US markets appreciated the announcement pushing up the stock to $460 on this announcement.

A buyback announcement by a company indicates what current promoters or board members think of its value. They initiate a buyback if they believe that the intrinsic value of the stock is much higher than the current value of the stock. Thus by utilising the excess cash with the company, promoters increase their stake by buying out willing sellers from the open market.

But that is theory. In India most companies misuse buyback rather than use it to increase their stake. Data collated by Securities and Exchange Board of India (Sebi) shows that in 2007 that only 6 per cent of shares which were put up for buyback were actually bought from the market. This ratio, however, increased as the markets went down in subsequent years and touched a high of 60 per cent in 2010-11. However, the fact that Sebi has to come out with a tougher set of rules to discourage companies from announcing frivolous offers suggests that companies use buyback announcements to give a support to their share prices, at least psychologically.

A buyback announcement, which will happen at a particular price, gives the impression to the investor that there is support at the buyback price and shares will not fall further as the company will come and purchase shares from the market. But the track record of companies shows that even when prices are below the buyback threshold level, few complete their buybacks.

Given this background Sebi’s tightening of buyback norms is a welcome step and will result only in genuine players making such announcements. The market regulator has made it mandatory for companies to buy back at least 50 per cent of the offer, else a penalty of up to 2.5 per cent of the total amount earmarked will be charged. Further, companies will have to keep 25 per cent of the buyback amount in an escrow account and complete the buyback in six months as compared to one year currently. There will also be a one-year cooling off period between two buybacks and companies will not be allowed to raise funds during this period.

For a long term investor, the company's earnings per share will rise after the buyback is completed as the bought back shares will be extinguished, which should result in the stock price going up if the valuation remains the same. Buyback also means more dividends to be distributed among the residual shareholders in future years.

On the negative side, a buyback signals that the management has fewer growth plans and there can be a topping of growth in the company. But in times of slowdown, like the current one, where the management is unsure of political and economic conditions in the country, buyback is one of the best ways to reward shareholders. 

The new rules would likely see fewer announcements, but the ones that do will be the stocks to watch out for.